REQUIRED READING: Four years have passed since the early waves of widespread default began to buffet the mortgage industry, but there still are too many people in our industry who believe that the problem started with subprime lending. For them, the solution is simple: Don't lend to borrowers who fall below a certain credit score.
Not only is this an erroneous assumption, but it is also a great way to limit one's market. After all, some of the least-risky mortgages are not reflected by the borrowers' credit scores.
There are thousands of borrowers with credit ratings that only improve throughout the duration of their mortgages, and who deliver as solid a performance as any prime borrowers. In short, the nonprime market is a dramatically underserved market, and the way to service that demographic successfully is with the use of due diligence in underwriting.
Most people don't use the term ‘due diligence’ when discussing mortgage underwriting. Instead, it pops up more often when researching a potential acquisition or merger. But make no mistake about it: A good mortgage lender with a worthy portfolio does due diligence on each and every mortgage loan it makes.
It is now a widely accepted belief that the default explosion that started around 2007 was caused – at least in part – by questionable or insufficient underwriting. Whatever the exact cause, there is no question that staggering numbers of mortgages were issued that did not fit the borrower or the borrower's circumstances.
Today, many mortgage lenders are reacting to the ramifications of that approach by categorically rejecting entire market segments – the credit score reigns supreme and is non-negotiable. However, with proper due diligence in the origination and underwriting process, a mortgage lender can safely (and profitably) lend to nonprime borrowers.
This due diligence begins with manual underwriting. This is not to say that underwriting software should be discarded or ignored. But too many of these programs allow little to no adjustment for changing market conditions, and too many are not updated quickly enough to reflect the rapid back-and-forth of today's mortgage market.
Even programs that re-evaluate the model and the process regularly do not perform with adequate speed or accuracy. In short, automated underwriting cannot and should not replace the human mind and manual underwriting on a grand scale.Â
Of course, just making use of manual underwriting is not enough. Good underwriters are trained well and often. They are empowered and provided with the resources necessary to conduct due diligence, and they perform as much research as necessary.
Another critical ingredient in due diligence is the ability to match the appropriate product to the appropriate borrower and his or her circumstances. Some would argue that the subprime meltdown was as much a function of inappropriate product as it was due to unfit borrowers.
However, the Center for Community Capital of the University of North Carolina has been conducting an ongoing study since 2001, comparing the performance of the loans originated through the Community Advantage Program (CAP) – a partnership of Self-Help, the Ford Foundation and Fannie Mae – to the more standard subprime products of the last several years. In fact, the group found that although the borrower demographics were very similar, the performance was not.
‘We find that for borrowers with similar risk characteristics, the estimated default risk is about 70 percent lower with a CAP loan than with a subprime mortgage,’ according to the center's report. ‘Though CAP has some program-specific characteristics, the results of this study clearly suggest that mortgage default risk cannot be attributed solely to borrower credit risk; the high default risk is significantly associated with the characteristics of loan product.’
Some bad timing
This point was affirmed by Larry Roberts, author of the 2008 book ‘The Great Housing Bubble.’ In his May 20, 2010, column on the Irvine Housing Blog, Roberts blamed the subprime collapse, in part, on the timing of the defaults.
‘Since [the subprime] loans were set to blow up after only two years, they defaulted first,’ Roberts wrote. ‘And since the housing bust began with their defaults, lenders followed their pre-bubble loan loss mitigation procedures and foreclosed on them. Subprime borrowers got kicked to the curb. Contrast that to what has happened to the Alt-A and prime borrowers whose loans were just as toxic as subprime loans: They have been allowed to squat.
‘What's worse is that the entire housing bust has been erroneously blamed on subprime borrowers, because their defaults and foreclosures came first,’ Roberts continued. ‘The narrative being spun today is that the Alt-A and prime borrowers would have been fine if not for the subprime fiasco. That is nonsense. The only difference between the groups was the timing of their loan resets and the response of the lenders. Subprime loans reset first, and lenders foreclosed. Alt-A and prime loans reset last, and they are being allowed to squat.’
Due diligence is all about taking the time and utilizing the resources to review a potential borrower beyond his or her credit score; training and preparing our underwriters to understand the borrower's history and performance in light of ever-changing market circumstances; and training loan officers to pair the most appropriate product with that borrower's abilities – even if it is not always the most profitable for the lender.
That may sound difficult, but it is actually quite simple. We are facing historically volatile market conditions: Borrowers do not fall neatly into the classes they once had, and predictability is far from high on loan performance with any borrower in our uncertain economy. Therefore, it is crucial to empower underwriters to do the due diligence necessary to make a reasonable decision on each and every mortgage.
Andrew Peters is CEO of McLean, Va.-based First Guaranty Mortgage Corp. He can be reached at apeters@fgmc.com.
